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A case for alternative investments in your portfolio

by Lesotho Times
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Ongoing disruption to the global economic and financial order, to the geopolitical balance, and to the scale and scope of government policy interventions, has defined the first three years of this decade and will, I believe, remain a new reality that investors need to recognise in the short to medium term.

Global stocks have volatile and on the bullish side so far in this year, despite skittish investors on global capital markets. The decline in stocks has been happening simultaneously alongside, higher interest rates in the US, gold and dollar rally, with the dollar index closing in on the highest point seen over the past year.

The current global market turmoil has made it painfully clear that returns are driven by asset allocation decisions based on macro views as opposed to managers who are selected according to their perceived ability to pick stocks. The recent global market volatility swoon has given investors an opportunity to rebalance, their portfolios and their asset allocation strategies. This may help investors to construct prudent, resilient portfolios without relinquishing upside potential. Accordingly, the current market narrative emphasises increasing return divergence between and within asset classes. Increased differentiation of returns across sectors and asset classes creates opportunities for tactical management. During such volatile episodes in markets, investors who are looking to de-risk and diversify their equity allocations for example, while earning attractive return potential, might look to alternative investments.

Investors should consider diversification in asset classes to protect assets from market movements and generate higher returns at acceptable risk levels. The investable universe that once centred on two asset classes’ equities and bonds has been greatly expanded by the inclusion of alternative investments, in the form of real estate, private equity, currencies, commodities like gold, silver, grains, or oil, intangibles and subject to regulatory approvals international stocks and cryptocurrencies. Moving out to the far fringes of alternatives, some other options include art and collectibles, wine, farmland, and peer-to-peer lending.

In some cases, investors can invest in a fund that covers multiple individual assets within one of these other classes. For example, exchange traded funds (ETFs). Real estate funds can also bundle multiple properties into one fund.

Alternative investments complement stocks, shares, bonds and other traditional financial instruments traded on financial markets. There is a large variety of alternative investments, and the list evolves over time. Both alternative assets (such as real estate) and alternative strategies (hedge funds) are classified as alternative investments. Alternative investments generally have lower liquidity, sell in less efficient markets, difficulty in determining current market values, limited historical risk and data, require extensive investment analysis and require a longer time horizon than publicly traded stocks and bonds. Alternative assets are not traded on exchanges and alternative strategies involve the use of traded assets for the purpose of isolating market risk and generating excess returns.

However, like any other investment, before making committing resources into alternative investments the investor must be clear about his or her financial situation, key investment objectives, risk return/ profile and near to medium term liquidity needs. Based on these factors one can determine whether a specific alternatives strategy may be appropriate for one’s portfolio.

When liquidity is present, it can make alternative investments, such as real estate attractive, but are there are cases in which the general illiquidity of alternative investments attractive? Alternative investments beckon investors to areas of the market where alpha (risk adjusted return in excess of the required rate of return) is more likely to be found than in more liquid and efficient markets. Illiquidity, limited information, and less efficiency do not suit all investors but can be attractive features to those looking for likely places to add value through investment expertise.  Some affluent investors are well prepared to sacrifice liquidity for higher return potential.

Investors can utilise alternatives in their portfolios as this might result in higher return potential. This motivation is most prevalent with ultra high net worth clients. This higher return potential is often driven by investing in less liquid and or more complex assets, along with greater concentration in high conviction ideas. Greater ability to implement hedges and focus on less trafficked, more complex markets can provide investors with potentially attractive, risk adjusted returns and relatively low correlations to traditional stocks and bond markets.  Returns may also be driven by use of leverage to varying degrees.

Alternative investments have potential diversification benefits. Some alternatives take different risk-factor exposures than traditional stocks and bonds. This may help build portfolio resiliency and mitigate downside risk. Certain alternative investments, in developed markets have flexibility to implement market neutral or short positions across all financial markets, providing the potential for explicit downside protection.

Exposure to esoteric asset classes in alternative investments can provide alternative betas- non traditional investment exposures- that are not easily replicated or accessed in other ways. Certain alternative investment strategies have the potential to help enhance income in investment portfolios beyond which traditional beta sources generate, especially during periods of low interest rates and yield spreads.

Alternative investment strategies can allocate across both private and public markets, providing exposure to a wide variety of asset classes that are not accessed to a significant extent via traditional vehicles.

When used appropriately, alternative investments can potentially enhance the overall risk- return profile of investment portfolios. They have unique benefits but also have unique risks associated with them as non traditional investment strategies, and as such it is important that investors be comfortable with particular alternatives when incorporating them into their investment strategy.  Therefore, it is important to clearly understand the objectives and constraints of each investor, to determine the suitability of incorporating them into their existing investment approach, as each individual’s circumstances are quite unique. Alternative investments are not a substitute for traditional asset classes, and they may be better viewed as compliments for achieving the desired risk- return profiles. Alternative investments are very important for the strategic asset allocations by all investors. 

An allocation to alternative investments may provide a different way to diversify your portfolio. Historically, alternative investments have exhibited low or even negative correlations with the stock market. Alternative investment strategies, when used prudently, can an important both in preserving and growing investment portfolios.

Capital markets can transition from periods of low volatility to periods of extreme volatility, investors must be prepared for those transitions. A flexible multi sector investment strategy may offer benefits to investors in uncertain markets- including potential to become defensive than traditional equity and bond strategies, when interest rates rise and volatility peaks. Alternative investments may complement core equity and bond exposures and diversify interest rate risk and equity volatility. Most importantly most alternative investments have a low correlation with traditional equity and bond classes, this helps diversify risk portfolio risk and act as downside risk mitigation.

However, like anything, there are pros and cons of investing in alternatives. On one hand, they provide diversification for your portfolio and the potential to generate returns or alpha in one area of the market when other areas are falling. On the other hand, alternatives are more complex than conventional assets and usually very illiquid. Investors are always advised to consult with an adviser and do their due diligence before investing in anything.

When most people think about investing, their mind goes to the most common types of investments, like stocks or bonds, or their investment accounts. However, there is a wide array of investment options that can help you diversify your holdings so you are better prepared in the event of a major market meltdown. Essentially, alternative investments are supplements to traditional long-only positions in stocks, bonds and cash. For investors who are willing to sacrifice liquidity in search of potentially higher long term returns and flexibility to protect against the downside, alternative investments can be the solution given the current backdrop in financial markets.

Until next week enjoy making money on capital markets. 

Thinking of buying or discounting bonds, Treasury bills, equity trading and capital markets news and information? Contact us today. 

Leonard Nyambuya
Katleho Securities, (Member of Maseru Securities Market)
+266 50709178, 53230700, 68730055
lnyambuya@katleho.co.ls, securities@katleho.co.ls, www.katleho.co.ls
Plot Number 12292-972 Mabelebele Street, Katlehong, Maseru, Lesotho

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